Educational Articles

Stock Screen: High Price-to-Earnings Ratios - May 21, 2014

Kevin Downing
| May 21, 2014

Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20.0. Each dollar of earnings is worth $20 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $40.00 for each dollar of earnings.

The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or not. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical norms, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple.

Every week Value Line publishes screens of the highest P/E ratios in the Index section of The Value Line Investment Survey. For this screen, we have chosen to highlight Craft Brew Alliance, Inc. (BREW).

Craft Brew Alliance, Inc.

Craft Brew is an independent brewing company that was formed through the 2008 merger of Widmer Brothers Brewing and Redhook Ale Brewery. It is comprised of five craft beer and cider brands:

Importantly, Anheuser Busch Inbev Sa Nv (BUD)owns more than 30% of Craft Brew Alliance, giving the company access to that beer behemoth’s vast distribution network. This is a competitive advantage because many times, craft brewers are excluded from “getting on the trucks” due to competitive dynamics and limited capacity.

The balance sheet is in decent shape. Although Craft has little cash on hand, debt levels are modest. Should the company find a brewery or two to add to its stable, we think it would have little trouble borrowing or going to the equity markets for the necessary capital.

Currently, Craft is operating in a challenging operating environment. Craft breweries are expanding as more and more individuals migrate away from mass produced beers to the arguably more flavorful craft varieties. Although this is certainly good for the company overall, it has brought more competition for finite shelf space and tap handles. Furthermore, there has been significant levels of public “infighting” between small and large breweries and trade organizations, as they battle for position and favor from customers, retailers, and politicians.

The company put forth a solid performance in the first quarter. Net sales grew 20%, and shipments to warehouses were up 17%. The discrepancy can be attributed to increases in revenue per barrel. Depletions, or sales of beer barrels from wholesalers to retailers after Craft has already sold them to the warehouses, were only up 8%. The reason for the gap was an inventory correction. The company said it believes wholesaler inventories are now at appropriate levels, and anticipates fairly tight alignment for the remainder of the year. Notably, the company was able to achieve these results despite getting rid of 25% of its beer offerings recently. This was done to reduce complexity and improve operational efficiency.

Rationalization of its product lines is not the only initiative being undertaken to improve profitability. The company is focused on improving its supply chain, optimizing brewing locations and improving capacity utilization. These efforts helped the gross margin grow 260 basis points in the first quarter, and BREW thinks it can expand that fundamental 500 to 700 basis points over the next five years.

Although recent results were within the company’s expectations, investors were not impressed, and the shares have fallen over 25% since the last earnings call. The stock’s price-to-earnings ratio is still relatively high, but is now hovering at a more reasonable 35. The company also left its 2014 guidance intact. It expects depletion growth to range from 7% to 11%, with average price increases of 1% to 2%. Growth in export revenue is expected to be between 25% to 50%, a result of new partnerships.

Although these shares are a relatively costly option, we think they have solid long-term growth prospects. We doubt the popularity of craft brews will wane, and think the recent dip in the share price has created a favorable buying opportunity for growth investors with and appetite for risk.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.